UBS: Cross-Asset Volatility Contracting … Watch US dollar!!

From the FXWW Chatroom: US Trading: Last week we again highlighted the extreme overbought position of the SPX and suggested the risk of a near-term pullback into early September before moving higher into deeper/later September, where we expect the US market to move into a more important tactical top on the back of an increasing number of divergences on the macro side, too low volatility and a strongly rising SKEW/VIX ratio, which is normally a leading indicator for more important tactical tops. Our near-term roadmap is unchanged. With an intact short signal in our daily indicator work, we expect more consolidation work into later this week/worst case next week before starting a new bounce higher into deeper/later September. On the sector front, our focus into September remains on cyclicals where in oil stocks we see our suggested breakout attempt. Bank and broker stocks are trading at their 2015 downtrend and remain in a make or break situation. Semiconductors continue to outperform but are clearly overbought so we would not chase the SOX on current levels.
*        A break of the 2175 trading support would imply a pullback to the early July breakout resistance at 2134/2120. On the upside, a break of 2194 would pave the way towards 2200/2260 into deeper September.
*        Over the recent months, the cross asset volatility on the macros side has been contracting across the board in equities, FX, bonds and gold, which is quite unusual. Given that we think the June/August rally in risk is mature, it is very likely to see generally rising volatility in financial markets in September/October where historically we have very often seen significant correction moves. Tactically, we would be a buyer of volatility!!
*        US Strategy: Since late May, we have been discussing what we need to see to get confirmation that the SPX is trading in a wave 5 of a larger degree, where our focus was on market breadth, sector leadership, and breaking the pivotal early Q2 top.
With the early July breakout, we got a strong impulse in our breadth indicators. Sector-wise we got initial breakouts in cyclical key themes but at the end of the day it was the break of the May 2015 all-time high at 2134 that gave us the ultimate confirmation that the SPX is trading in a wave 5 of a larger degree, which is de facto confirmation that the US market trades in a new cyclical bull market that should last minimum into H2 2017 and more likely into H1 2018. However, this bull market will be not a one-way. From a cyclical/tactical standpoint, we see the risk of a more significant correction from later September into initially later October/early November and finally into late Q1 before resuming the underlying bull cycle. So the whole wave 5 bull cycle will be very likely highly selective (regionally and thematically) and also highly trading oriented, where from a trend perspective our focus remains on cyclical out performance.

*        European Trading: On track with our last week’s call, Europe is in consolidation/pullback mode where we expect to see more near-term weakness into ideally later this week/early next before starting another bounce higher into deeper/later September. Generally, from a cyclical aspect we also see Europe moving into a more important tactical top in later Q3, so that a bounce into September will be very likely limited in price and time, which will be quite critical. Again, if the Euro Stoxx is unable to break its pivotal April top at 3157 (where the 2015 bear trend comes in) we have the risk to see another potential litmus test on the downside into later October/early November where we cannot rule out a re-test of the February/June bottom at around 2670.
  *   Inter Market Analysis: Keep an eye on the US dollar!! Since the July reaction high at 97.60 we have seen a corrective a-b-c pullback in the DXY, which is normally a constructive medium-term setup. Short-term, the DXY is oversold and we expect a new bounce starting. Pattern-wise, we see particularly in some Asian/EM pairs, significant breakout patterns forming. A breakout would imply that a bigger USD rally is underway where minimum a re-test of the pivotal July high would be in the cards. Generally, in our cyclical model, a break of the July high at 97.60 would trigger a big medium-term buy signal in the DXY into Q1 2017. In this case we could clearly anticipate an attempt to break its key resistance at 100.

From a macro standpoint, a higher US dollar suggests higher interest rates where the US 10-year Treasury yield trades in a triangle breakout pattern. A higher US dollar accompanied by higher interest rates would be short-term headwind for gold, commodities, and Emerging Markets, which all in all would imply higher cross asset volatility.
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